How to Become a Value Investor – Whether You’re Passive, Active, or a Barbarian at the Gate

While it’s fun to write about razing villages and executing your enemies to get M&A deals done, such extreme violence is not everyone’s cup of tea.

Plus, you might just want to invest in companies rather than buying or selling them outright.

So if you dream of starting your own hedge fund or asset management firm one day – or even investing independently – you’ll need to learn about all the different strategies you might pursue.

At the top of that list is value investing, made famous by financial luminaries like Ben Graham and Warren Buffett.

Whether you’re interested in more passive strategies or you consider yourself a contrarian, there’s something for you in value investing.

And if you really are a barbarian and you’re interested in burning down villages and ransacking civilizations so that you can use the proceeds to buy your own country one day, there’s still a value investing strategy for you.

Why Value Investing?

The core concept is pretty simple: you buy stocks for less than their underlying values.

Then, once you hold onto the stocks for some period of time, you can sell them and earn a profit assuming that their share prices increase and approach the true underlying values.

Value investing would tell you to buy that stock because the market is undervaluing it.

Although the concept is simple, value investing is extremely difficult to implement properly and requires rigorous analysis to determine what the “underlying value” of a stock is.

Thanks, Ben Graham

Back in the 1920s and earlier periods, investing focused mostly on bonds since common stocks were viewed as “too speculative.”

Yes, those really were the 2 main asset classes: this was long before financial weapons of mass destruction, CDOs, and all the “creative” inventions of the financial services industry since 1980 or so.

Since investors focused so much on bonds, common stocks were under-analyzed and that created many investment opportunities – assuming you properly estimated the values of those stocks.

In this period, Ben Graham came along and earned a reputation as an up-and-comer on Wall Street by consistently finding profitable investing ideas – and he decided to record his investment knowledge for posterity.

If that book had never been released, “investing” would still be viewed the same way as gambling today – and your parents would be even more pissed off that you want to go into finance rather than becoming a doctor or lawyer.

He followed it up with The Intelligent Investor, which brought his investment philosophy to the masses; Warren Buffett later described it as “the best book about investing ever written,” and I don’t disagree with that assessment.

Ben Graham’s students and followers went on to enjoy huge success on Wall Street by applying his philosophy, which is why the concept of value investing spread far and wide: you couldn’t argue with the results.

What Is Value Investing?

It’s easiest to think of value investing on a continuum from passive to active (yes, we’ll get to the part about razing villages and ransacking civilizations in a bit).

With passive strategies, you simply buy cheap stocks and wait for the market to recognize their full value.

On the other end, with active strategies, you buy cheap stocks and then attempt to “make” the market realize the value of the stock by changing the company itself.

In the middle, most value investors use contrarian strategies.

Passive Value Investing

With passive value investing, you screen for undervalued stocks based on certain financial criteria, such as Price / Book Value (P/B) or Price / Earnings (P/E) ratios.

In Ben Graham’s day, these screens were often simple and involved only P/B ratios or simple comparisons of market value to net cash.

When you think about it, if you could find a company priced less than the net cash (cash minus debt) on its balance sheet, your downside is minimal unless management is so incompetent that they destroy value. Ben Graham used this same simple process to great success for many years.

But then other investors started noticing what he was doing, and imitators sprang up – and the number of stocks trading below their net cash dwindled to 0.

Rather than just using Beta to describe the returns of a portfolio or stock, as with the traditional CAPM model, the Fama-French model also adds in other factors such as whether the stock is a small-cap company and whether it has a high book-to-market ratio.

Investors continue to debate which screens “work” most effectively and how complex you should make the screens, but the fact remains that value screens outperform over time.

Sometimes the exact metrics and screens change, but the value philosophy of buying only discounted stocks remains the same and continues to outperform the market.

What Firms Do Passive Value Investing?

Almost anyone could use passive value investing as part of their investment strategy, so it’s not limited to just pension funds / insurance companies / hedge funds or anything like that.

If you’ve ever invested in a stock because you believe it was undervalued based on a value screen and then left your investment alone, that’s an example of passive value investing.

On a bigger scale, there are plenty of asset management firms that use passive value investing – a better-known example in recent years has been the rise of fundamental indexing. Traditional index strategies weight stocks by market cap, whereas fundamental indexing strategies weight by fundamental value metrics such as book value or earnings yield.

Contrarian Value Investing

Contrarian value investing is the most common type of value investing.

Most of the big names in value investing, from Warren Buffett to Seth Klarman to Marty Whitman, are of the contrarian type. Contrarian value investors take delight in zigging when the market is zagging; they like to buy stocks on the cheap when everyone else has assumed that the companies have died or are on their deathbed.

The idea here is that the market often overreacts to news or events – maybe Apple missed its quarterly projected iPhone sales but then sold 4 million units of its new model in 3 days.

In that scenario, their stock price would likely drop as investors overreact to one part of the news and ignore other positive signals – so the contrarian investor would pick up on that and invest in the stock as everyone else is selling it.

Academic studies have supported contrarian value investing and have shown that buying a portfolio of stocks that underperformed the prior year outperforms a portfolio of stocks that outperformed in the prior year.

Just because you’ve found a stock that’s undervalued and that has been abandoned by everyone else doesn’t mean that the stock price will immediately go up just because you bought it – it might take months or years for the market correction to occur.

Great companies that the market loves are often priced like great companies the market loves – as Warren Buffett has said, “You pay a very high price for a cheery consensus.”

So with contrarian value investing, you buy when the market is selling and wait for the market to recognize the true value of the asset you’ve invested in.

What Firms Do Contrarian Value Investing?

The most famous example, of course, is Berkshire Hathaway – Warren Buffett has practiced contrarian value investing for decades, and in the wake of his success numerous imitators have sprung up.

Insurance companies and pension funds tend to use asset allocation strategies rather than following the market quite this actively, so it’s not as common there (with a few exceptions, such as Swensen at Yale).

Activist Value Investing

Finally, what you’ve been waiting for: vanquishing your enemies to earn high returns.

Activist investing is similar to contrarian investing, except the companies you target are cheap because the management team can make changes to boost their value.

Let’s say that the activist investor identifies a conglomerate that has multiple subsidiaries in different businesses – retail, consumer staples, and healthcare.

The investor might value each different line of business and determine that one of them – consumer staples, let’s say – is “dragging down” the value of the entire company by under-performing and being valued at a lower multiple than the other segments.

So the activist investor might then acquire a small portion of the stock and then meet with the management team to “convince” them to sell off the under-performing subsidiary.

Usually discussions ends there because public company CEOs rarely want to rock the boat and do something dramatic – so that’s when the activist investor takes his case public and starts lobbying the Board of Directors to adopt his proposed changes.

If the management and Board refuse to sell off that subsidiary, then a proxy fight might result and the activist investor might bring their proposed changes to a vote of shareholders and persuade other investors in the company to join their side.

While it’s not quite the same as invading countries and killing your enemies, you can see how activist investing is the most aggressive of the value investing strategies: you come into direct conflict with the leadership of the company, and there may well be “casualties” on both sides.

Keys to Success in Activist Investing

As an activist investor, you could propose almost anything to “unlock” more value in the company you’ve targeted:

Spinning off subsidiaries

Using cash to buy back stock

Selling the company to a private equity firm or another public company

Rejecting an acquisition offer from another company

Liquidating certain assets

Changing the capital structure

Issuing dividends or otherwise disbursing of cash

Changing the management or Board or cutting compensation

You need to analyze every aspect of the company and situation in question and figure out which action would increase its value the most.

The whole process can take months, if not years. Even though you come into direct conflict with management, it’s more of a drawn-out war of attrition rather than a quick skirmish.

You need a lot of patience and persistence because management teams often defend the status quo at all costs – even when everyone else knows they’re wrong.

And you need lots of capital because you need to control a significant enough portion of the company to make yourself noticed – no one will care what you think if you only own 0.001% of shares outstanding.

When you’ve acquired over 5% of the company, though, your demands are taken more seriously.

What Firms Do Activist Value Investing?

Overall, fewer firms practice activist investing because it’s more resource-intensive and prone to failure; with other forms of value investing, you might lose money or not make as much as you expect, but you don’t spend years locked in a war of attrition with an entire company.

The most well-known activist investor is Carl Icahn, who has won Board seats at numerous companies and attempted to break up huge firms like Time Warner over the decades (sometimes succeeding at doing so).

Other examples of famous activist investors and hedge funds include Dan Loeb at Third Point, Bill Ackman at Pershing Square, and even “boring” mutual fund managers like Bruce Berkowitz at Fairholme (see the St. Joe turmoil) can get into the activist business.

Activist investing is far more common among hedge funds than other types of buy-side firms because it’s such an aggressive strategy – the average pension fund or asset management firm is not prepared to spend years staging a public battle with a company.

How to Break Into Value Investing

Regardless of whether you want to get into a value investing-based hedge fund, asset management firm, or anything else that manages money, you need the proper mindset.

If you lack patience and need immediate gratification, you’ll never make it.

How you get on the radar of these firms and land interviews in the first place is already covered in the hedge funds vs. asset management article, as well as all the other networking advice on this site.

Many hedge funds are secretive and list little to no information online, so you’ll need to be more creative and go through sources like LinkedIn to find names; it can be easier to find information on asset management firms, but even there you’ll have to do a lot of aggressive networking because smaller firms don’t do much recruiting out in the open.

Another strategy is to target the large asset managers like Fidelity and focus your efforts on their value-based strategies. Most of the big asset management firms have multiple strategies and “value” is usually on the list.

In interviews, they will spend a lot of time not only assessing your investment ideas, but also assessing your personality – even down to something seemingly irrelevant like your retail shopping habits.

When you pitch stocks in these interviews, you need to focus on investment ideas where the value investment philosophy applies: you shouldn’t go in and pitch an idea that depends on short-term momentum or volatility because they’ll assume that you won’t mesh well with their investing philosophy.

Even better yet, show them investments you’ve made in your own portfolio, explain why you made them, and how each one fits in with the value investing philosophy.

And be prepared for those seemingly unrelated questions on your behavior: if they ask you how you buy your clothes at the mall, what would you say?

If you don’t know the correct answer by now, you don’t understand the value investing mindset.

The only correct answer is, “On sale. I only buy when what I want is on sale.”

What Next?

You can find tons of information online about value investing, but you’re best off going to the original source and reading Ben Graham’s The Intelligent Investor. Read and re-read this book if you want to absorb the full mindset and understand the fundamentals that will never change.

And if you still have your sights set on destroying villages and beheading your enemies to succeed, give up on investing and go into M&A – or give Carl Icahn a ring, pitch your activist investing idea to him, and hope that he has positions available.

Comments

I would disagree that Warren Buffett is a contrarian investor. Yes, he has said “be greedy when others are fearful, and fearful when others are greedy”, which is 100% contrarian.

However, Warren Buffet has went through many different phases of investing. He started out with the cigarette butts, or picking up really cheap stocks that were so cheap, they were almost free but still had some value left in them. He then looked for great companies and did not care AS much about the price, he looked for great businesses and bought them even at so-so prices. Most recently, many say that he is even willing to pay a higher price than ever for companies because he believes they are great businesses that he would like to hold on to for forever.

The original Buffett, the one that strictly followed Graham and Dodd, I would say is a contrarian value investor. I would place Seth Klarman in this category as well.

If you look at his most recent acquisitions, many of them are contrarian strategies, (Bank of America) but many of them also were not taken when there were bug sell-offs. He merely bought them at prices he thought were reasonable and would provide greater than value than for the present value of it today.

I would say one of the most difficult parts about Value Investing is having the conviction that your analysis is correct, AND being patient enough to wait. After doing your analysis, you might believe there is 25% upside potential. But how long do you wait? You might wait a few months, almost a year, 1 year, 2 years, and then you start to think “wow, I might have been wrong about this investment.” And then you sell. You have to be confident in your analysis, AND also be patient enough to wait for the market correction.

Securities Analysis is really long and dry, I couldn’t finished. The Intelligent Investor is the best elementary book to value investing in my opinion. Interpretation of Financial Statements explains accounting very well.

I work in Operations / BO.I’m with a Corporate actions group where my role is mainly to support Fund Accountants. Given this background how is membership at VIC (value investors club) viewed by Mutual Funds . Much of what i do is accounting for tenders, cash/Stock mergers, Splits, Spinoffs, Right issues,bond exchanges and ID changes.

I would like to be at the other end (making those buy / sell decisions)

It is good to demonstrate your passion for investing, but it won’t land you a front office job by itself. You’ll need more networking, taking the CFA exams, maybe going back to get an MBA, etc. to move to the front office.

I will give my 2 cents here. Whatever Mike said is absolutely true. However, you need to walk the talk. Keep investing philosophy in mind whenever you take the monetary decisions. Start a blog & share your investment ideas, network like crazy. I believe value investing is much more than statistical models. Read about Charlie Munger. The man is simply great when it comes to keeping emotions under check…

Thank you very much for this post. I have always been interested in value investing (an in Warren Buffett, by the way).

What is your take on Security Analysis and and Graham’s less popular Interpretation of Financial Statements. The needs of what crowd are catered in this books, when should one read it and how applicable are they (considering different business models and accounting rules)?
I am currently reading Intelligent Investor and am already looking for the next step. To me it seems like a cmobination of Buffett Shareholder/Partnership Letters and Security Analysis is suitable. Any thoughts on this? Thanks in advance.

Hi M & I. I have an off topic question. I did an internship at a research think tank at a top US business school (Ivy), and the title of the position was “research assistant.” I worked for two project managers who were pretty chill.
Can I put down that I was a “research analyst” instead of a research assistant on my resume and on LinkedIn? I want to do this in an effort to bankify my experience. What do you think? I appreciate your input, or any other suggestions.

Can they “verify” your title name if they were to ask for references and past records? If not, I don’t think its such a big deal.
Yes the experience is relevant though not directly relevant….more relevant to equity research.

Unrelated to this article, but I had a question about MSF programs. I am a senior now at a target university, turned down my return offer from the bank I interned at (exploding offer, and was a regional city), and am going through recruiting now.

If nothing pans out for full time, could I apply to MSF programs and go through summer analyst recruiting?

Unrelated again, but just wanted to say thanks for all the help this site has offered me. Networking paid off in a lot of interview invitations, and one of those interviews ultimately paid off in an offer with a solid bank in my top choice location.

Interesting points, but don’t you feel that most people should just stay out of the market? I think that only a very small proportion of people make actual good investors who can consistently beat the market based on publicly available information. That’s why I gave up on investing in individual stocks; these days I just dump what I have in index funds and let it slowly appreciate.

It just didn’t feel worth the hassle. Having to analyse and pick stocks. Worrying about whether my chosen stocks are going to crash. Checking the damned SEC restricted list and client firm list every time I want to pick something up.

By the way, I feel that PE and VC firms could be lumped in under activist investors, because they seem to fit the requirements. Strategic investors are activist investors too, of a sort; the main difference would be that they’re not aiming to unlock value in terms of stock price, but value in terms of actual cash flows or other productivity.

Warren Buffett has beat the S&P 500 in every five yard period since he incorporated as Berkshire Hathaway in the 60’s. Putting that all to luck gets into very small probabilities. Putting all other true value investors outsize gains to luck, such as Seth Klarman, and the probabilities become pretty much zero.

EMH-advocates trot out the fact that most people in any given year beat the market as some indisputable evidence that we should just all buy index funds. The issue with yearly relative returns is not negative percentage are much more bad than positive percentages are good.

For example, if the stock market goes down 50%, then the market has to go up 100% to get back to its prior level. That’s why the five-year returns for Buffett compared to the S&P are so important. Value investor buy only when (they think) stocks are undervalued, while EMH-types say buy stocks whether we’re in 2000 or 2009.

BTW, all that said, normal people SHOULD index. It’s very hard and requires a lot of patience to find the stocks to beat the market. But it’s a myth that it’s absolutely impossible to beat the market. It takes a lot of patience and skill, but it can be done.

97 percent of mutual funds perform worse than index after costs. Sadly, I think this number is likely to grow. As the cost of information gets lower and easier to acquire via the internet, will there be any reason to employ humans to do actuall investment decisions?

You could say the same about hedge funds and other alternative investment firms as well, yet money keeps flowing in. And at the same time, a select few funds consistently outperform the market.

So I think what will happen is similar to what has been happening in the venture capital industry since 2000: the top performers survive and thrive, and everyone else in the middle and below goes away and has more trouble raising capital from LPs.

There will always be situations where humans have an advantage over computers, so I don’t think investing as a profession will go away.

That “97 percent” number has many issues. The S&P 500 is all large-cap stocks, but even mutual funds invest in all sorts of markets. Mutual funds really need to be compared to their constituent index (a small-cap fund to a small-cap index, for example). Mutual Funds still do fairly poorly, because of fees and because many funds have to be fully invested even if the market is overvalued. But they do not do nearly as poorly as that statistic.

Also, indexes have done “better” than many funds in part because indexation is a self-fulfilling prophecy. It becomes gospel to just buy index funds and suddenly indexing starts looking like a good investment. That can’t last forever though and returns will even out once correlation comes back down to earth, i.e. when investors start investing instead of just going into and out of index fund en masse.